SPECIAL REPORT: In March 2007, the Ohio Housing Finance Agency (OHFA) announced that it was issuing $100 million in taxable municipal bonds. On the surface, there was nothing unusual – housing finance agencies routinely issue bonds to help finance their endeavors. But this bond issue was very different: It was designed to help 1,000 families with the refinancing of their toxic mortgages.
‘We were the first state housing finance agency to roll out a refi product,’ recalls Douglas A. Garver, executive director of the OHFA. ‘There was no product for us to duplicate – we were on our own in that regard.’
In creating this bond issue, the OHFA broke an unofficial rule that governed both the U.S. mortgage banking industry and the national economy during this period of time: The agency stated clearly and unequivocally that the housing market was in peril.
‘Given what was going on in the Ohio housing market, we felt it was appropriate to take that action,’ Garver states.
Hindsight offers the proverbial 20/20 vision to diagnose what went wrong, yet the retrospective viewer looking back a mere four years can still have problems comprehending why this situation was allowed to metastasize out of control when so many warning signs were clearly visible.
An XXL-sized market
In the aftermath of the 2001 recession, the housing market began to grow. And grow. And grow. But from the beginning, there were some people who were concerned about this rapid expansion.
‘We became concerned in 2002,’ says Michele Rodriguez Taylor, executive director of the Chicago-based Northwest Side Housing Center. ‘There was a big push for homeownership. At the time, you did not need to put five percent down – you could do zero percent down. A lot of people in the housing counseling community put up a red flag, because people need to be invested in and prepared for homeownership. Potentially, it would be too easy to walk away if things crumbled.’
By 2004, the U.S. homeownership rate reached a historic peak of 69.2%; 10 years earlier, it had been 64%. During this period, Taylor found few people in the financial services industry that shared her agitation. She recalls an attempt to sound a warning bell during a 2005 conversation between housing counsel professionals and Wall Street investors.
‘We told them those loan documents were not sustainable,’ she continues. ‘We said, 'You're setting people up for failure.' We knew things would crash, but we had no idea of the enormity of the situation.’
Why didn't people listen? According to Dr. Ernest Goss, professor of economics at Creighton University College of Business in Omaha, Neb., federal policies encouraged increased homeownership levels.
‘The government was pursuing policies that put everyone in a house that wanted a house,’ he says. ‘In 2006 and 2007, the assumption was that if you had a job and income, you should have been able to buy a home – and see appreciation on the home so you can take cash out and spend.’
‘Much of the problem with the housing market stems from massive debt growth to fund the purchase of housing, particularly with low-down-payment loans,’ says Dr. Anthony B. Sanders, distinguished professor of real estate finance at George Mason University in Fairfax, Va. ‘Add to that the subsidization of homeownership through the interest deduction and guarantees for Fannie, Freddie and the Federal Housing Administration, and we overcooked the housing market.’
But the federal push for higher quantity levels was not mirrored with a push for higher quality levels, according to Edward Pinto, resident fellow at the American Enterprise Institute in Washington, D.C.
‘The government really expounded a social policy for loosening underwriting standards,’ Pinto says. ‘That was paired with Fannie Mae and Freddie Mac, the leverage and moral hazard kings. Most of the capital they raised after 2000 was through preferred stock, which was highly leveraged. They both invested capital in low-income tax credits – leverage on top of leverage.’
‘The housing market requires leverage and, therefore, more risk in the leverage market,’ Winthrop Watson, president and CEO of the Federal Home Loan Bank of Pittsburgh, adds, noting that this period was marked with similar activities overseas. ‘There was overconfidence that cut across financial markets globally. We can see remnants of that bubble today in Greece and other parts of Europe – the Spanish markets were even more over-leveraged than ours.’
During this period, Wall Street accelerated its position as the driving force in the secondary market as mortgage-backed securities (MBS) became a hot commodity. Originators found a huge demand among investors, thanks, in large part, to seals of approval from the credit rating agencies.
‘The boys at Standard & Poor's told us MBS were solid investments,’ Dr. Peter Morici, professor of economics at the University of Maryland's Robert H. Smith School of Business, says, adding that the housing market responded by greatly expanding housing construction. ‘Too many houses were built during the boom. Supply became greater than demand.’
With more houses being built, lenders worked hard to originate mortgages for new homeowners. ‘The financial services industry had the incentive to do what they did,’ comments Dr. Gregory Price, chairman of the Department of Economics at Morehouse College in Atlanta. ‘They were like pigs at a trough.’
‘The model that folks used on the origination side was, originate, originate, originate, and then sell off 100% of risk and repeat ad infinitum,’ says Steve Horne, founder and president of Wingspan Portfolio Advisors, based in Carrollton, Texas. ‘And the inevitable consequence of the quest for evermore volume is to convince yourself that it was good to originate mortgages you would have previously never considered originating.’
One of the vehicles that ferried more people into homeownership was the subprime mortgage. However, when the housing bubble began to deflate, many people who found themselves unable to repay their loans were holding subprime mortgages. Indeed, the people targeted by the OHFA's unprecedented bond issue were mostly subprime borrowers.
Before the OHFA's bond issue, however, some people within the financial services industry began to recognize that the subprime product was creating an abnormally high degree of problems – for both borrowers and lenders. Sue Allon, CEO of Denver-based Allonhill, recalls that international investors were the first to voice concerns that their U.S. counterparts did not wish to publicly acknowledge.
‘People who really knew this market were aware in July 2006 there was trouble brewing, when the European markets said, 'We don't think that subprime makes sense,'’ Allon says. ‘A lot of people got out of the securitizations they owned. Around December 2007, Wall Street gave its signal – they had no confidence in the subprime market.’
But as the problems with subprime mortgages began to boil, the federal government was insistent that its impact on the wider economy would be minimal, even infinitesimal. In March 2007 – the same month as the OHFA bond was issued – Federal Reserve Chairman Ben Bernanke stated that red flags did not need to be hoisted.
‘The impact on the broader economy and financial markets of the problems in the subprime markets seems likely to be contained,’ Bernanke said.
At the Department of the Treasury, the reaction to the subprime debacle was equally anodyne. ‘It seems to us that the situation is a manageable one,’ observed Robert Steel, undersecretary for domestic finance.
By June 2007, the Bush administration was still downplaying the difficulties facing the housing market and the mortgage banking industry. Alphonso Jackson, secretary of the Department of Housing and Urban Development, acknowledged difficulties but kept a sunny outlook.
‘We have hit a bump in the road,’ Jackson remarked. ‘What I would argue was a needed correction.’
The following month, the Mortgage Bankers Association (MBA) took Jackson's optimism to further lengths. At the annual California Mortgage Bankers Association conference in San Francisco, a hearty vote of confidence was registered by Douglas G. Duncan, senior vice president and chief economist at the MBA.
‘Subprime is not going away,’ Duncan insisted. ‘Subprime is alive and well.’
In all fairness, Duncan admitted that a problem existed – but only in terms of geographic isolation. He dubbed the rising tide of delinquencies as merely ‘a story of seven states’ – Arizona, California, Florida, Indiana, Michigan, Nevada and Ohio – and then predicted a brighter future for delivery by the end of 2008.
‘We believe we will see the peak in delinquencies in the next two to four quarters, and the foreclosure peak one to two quarters after delinquencies,’ he said. ‘So if we're right, then you'd expect the peak in foreclosures four-to-six quarters out.’
While Duncan was waiting for a sunnier future, a number of financial services entities were already following the OHFA's lead and rushing to help distressed homeowners. In April 2007, Neighborhood Assistance Corp. of America, with financial backing from Citigroup and Bank of America, announced a $1 billion undertaking to help refinance the mortgages of homeowners who faced losing their property.
Other financial institutions began offering their own programs and products to address the situation. State Employees' Credit Union in Raleigh, N.C., for example, created loan products to help their members get out of the subprime mortgages they received from other lenders. The credit union never originated subprime loans.
By fall 2007, the National Association of Business Economics conducted a survey of its members, asking whether subprime mortgages or al-Qaeda terrorists posed a greater risk to U.S. security. Thirty-two percent of those polled cited subprime mortgages, while 20% named al-Qaeda as the greater threat. When the MBA held its 2007 convention in Boston, the Massachusetts Housing Finance Agency and Fannie Mae were jointly financing a $250 million fund to help distressed Bay State homeowners who could not repay their subprime loans. Other state government agencies around the country were engaged in similar financial outreach.
Before the end of the year, ‘subprime mortgage’ became an epithet. Today, however, some people question whether the product – at least in its original concept – was actually at fault.
‘Subprime has been around forever,’ says Jim Hollerbach, president of Hollerbach & Associates, based in San Antonio, Texas. ‘There are people that may have income and the ability to pay, but they have lousy credit. They needed to go somewhere. The hard-money lenders have always been out there to make those kinds of loans, and finance companies also pushed those types of loans. But subprime became the area to put the blame in.’
‘I did subprime as a lender 20 years ago,’ says Edward Kramer, senior vice president at Minneapolis-based Wolters Kluwer Financial Services. ‘It was lending based on risk and adjusted interest rate according to that risk. It was not predatory lending.’
Yet as the housing market began to wobble throughout 2007, there was a rising chorus of charges that the subprime mortgages were being originated through predatory lending practices. Beginning with North Carolina in 1999, many states had predatory lending laws. However, there were no federal entities to regulate the non-depository mortgage lenders that were originating subprime mortgages.
Even more problematic was a 2004 order by the Office of the Comptroller of the Currency that said national banks were exempt from state predatory lending laws. In 2009, the Center for American Progress in Washington, D.C., issued a report that showed 14 ‘systemically significant banks’ and their then-current subsidiaries were responsible for originating more than one out of every three higher-priced subprime mortgages at the height of the housing bubble in 2006.
The blame game
A large percentage of subprime mortgages were originated under the banner of expanding affordable housing opportunities – which, itself, was a key component of the housing policies of the Clinton and Bush administrations during the 1990s and 2000s.
‘The government set very unrealistic goals in the mid-1990s for affordable housing,’ says Wil Armstrong, chairman of Denver-based Cherry Creek Mortgage Co. ‘It could even be traced further back to the Community Reinvestment Act of 1977. Owning one's home is part of the American dream, but it got to the point that some people did not realize that it requires prudent risk management and underwriting.’
However, Dedrick Muhammad, senior director of the economic department at the NAACP, expresses concern that many people within the financial services industry have blamed the housing crisis on the borrowers that the affordable-housing efforts were supposed to assist.
‘The primary mechanism of influencing the housing bubble was not government programs for low- and moderate-income people,’ he says. ‘The massive leverage that came through Wall Street created the crisis. Some people have an ideological view of politics: blame government first, and anything that the government does to help low- and moderate-income people should be viewed as suspicious.’
But other players within the financial services industry have also been blamed. Jim Kirchmeyer, CEO of Buffalo, N.Y.-based Kirchmeyer & Associates, considers an unhealthy collusion that existed between mortgage brokers and appraisers.
‘Brokers could order appraisals from their favored appraisers, which happened all the time,’ he says. ‘Someone did a survey and found 90 percent of appraisers felt pressure to produce appraisals at a particular value point. Appraisers were supposed to be independent third parties who were supposed to protect the lender and consumer.’
Brian C. Coester, CEO of Coester Appraisal Management, based in Rockville, Md., agrees that the appraisal industry shares some of the blame.
‘They had a big role,’ he says. ‘Obviously, the majority of appraisers are good, but a lot of appraisers were seriously pushing the envelope. And a lot of it had to do with pressure from loan officers and the aggressive stance of the market.’
However, Michael D'Alonzo, president of the National Association of Mortgage Brokers, rejects the idea that brokers facilitated the housing market's downfall.
‘That is totally unfounded,’ he says. ‘If you give brokers a product to sell, they'll sell it. If it is a 100 percent no-doc loan with a 510 credit score, they'll sell it. You cannot blame the messenger for delivering the product.’
There is also the question about the misuse of technology during this period.
‘We are an information-heavy society,’ says Ann Rutledge, founding principal of R&R Consulting, based in New York. ‘But we were not sophisticated with information technology during this crisis. There was a failure to use technology to properly measure when risks were being created.’
‘Technology vendors want to offer what's relevant in the market and what's needed,’ explains Arturo Garcia, chief operating officer at PLATINUMdata Solutions, based in Aliso Viejo, Calif. ‘If you encourage the processes in place – in this case, speeding up loan funding and closing – and you use automation to encourage these practices, then lenders and vendors feed on each other.’
Yet Garcia adds that it is wrong to simply blame the technology alone. ‘This may have been prevented if the risk departments in the larger organizations stepped in,’ he says. ‘But production was too busy, and that's what drives the industry.’
Within the mortgage banking industry, it appeared that too many underwriters were asleep at the wheel. Scott Reid, CEO of Bedford, N.H.-based Alpine Mortgage LLC, believes this was the first misstep in the mortgage banking industry's ultimate stumble.
‘From an underwriter's perspective, the problems started back in 2001 and 2002,’ he says. ‘The industry was creating products and different loan structures – like the interest-only mortgage, teaser-rates, option-adjustable-rate mortgages – all contrary to what took place in the prior 40 years. Once you go down that road, it is very challenging to get people to pull back.’
Avi Naider, chairman and CEO of ACES Risk Management Corp., based in Fort Lauderdale, Fla., does not believe in singling out one particular party for blame. Instead, he spreads the responsibility across the board.
‘The fundamental issue with the housing market – from the very, very beginning – was having a market built on misrepresentation,’ he says. ‘Borrowers would go to brokers and get loans based on a fundamental misrepresentation – their inability to repay the loan. The misrepresentation moved onwards and upwards through chain: These loans were packaged as high-quality loans, wrapped into securities, and accredited throughout the chain.’
But when the first major red flag was raised – the OHFA's aforementioned $100 million bond issue in March 2007 – the damage was too great to control, let alone mend.
‘We did not achieve the targets we set,’ says Garver about the bond issue. ‘There was a large number of families to help, and so many folks were already over the waterfall and underwater. But we learned from it and used it as a means to become much more involved in foreclosure prevention.’
Tomorrow: Part two of this four-part series will analyze the federal government's response to the housing market's collapse.